Tuesday Tip – The 5 C’s of Credit

July 17, 2018

Understanding credit is critical to your financial success and how you manage credit is an indicator of your financial health. Maintaining good credit can impact much more than just your monthly credit card statement. It’s smart to learn the ins and outs of credit before getting in over your head and wondering how to get out of credit card debt. After all, how could you expect to master anything in life without first studying its parts? No one would expect you to achieve a black belt in karate after one session. Credit is no different. So let’s take a look at the 5 C’s of Credit, what they mean, and how they can impact you.

The 5 C’s of Credit Explained

The 5 C’s of Credit are the criteria that helps creditors and borrowers make sound financial decisions. If you fall short in any area of the 5 C’s of Credit, your application could be denied. But, isn’t it best to know the decision factors in advance and have the opportunity to present the best application possible? With that said, here are the 5 C’s of Credit.

Character

When a potential borrower submits an application for credit, the creditor will evaluate the borrower’s character or integrity. A borrower’s character is evaluated through the information on their credit report, including repayment history, outstanding debts, length of credit history, new credit, and credit variation.

A borrower’s debt-to-income ratio is also a good indicator of character. This represents the percentage of one’s monthly gross income that goes towards paying debts. Keep in mind that as you pay off debt, your debt to income ratio will be reduced. You can also reduce your debt to income ratio by increasing your monthly gross income.

Capacity

Creditors also look at the borrower’s capacity, or ability, to repay loans. Does the borrower have enough disposable income to cover the payments? Disposable income is the money that remains at the end of the month after all your bills and living expenses have been paid. If your disposable income isn’t sufficient to cover the monthly debt payment, it is unlikely the creditor will approve your application.

Collateral

Creditors take a risk of nonpayment when they lend money to consumers. To reduce this risk, creditors will sometimes ask for collateral. Collateral is an asset used to guarantee repayment and secure the loan. Collateral can be the property you own that has monetary value, like a home or car. If the borrower does not repay their loan, the creditor can seize the collateral pledged for the loan as repayment. There are many benefits to secured loans and using collateral, but keep in mind that your property, and possibly the roof over your head, is on the line. Be sure not to commit to a loan agreement you may not be able to keep. Here are some differences between secured vs unsecured loans.

Capital

When creditors refer to capital, they are referring to net worth or wealth in terms of monetary assets. Net Worth = Assets – Liabilities. Having a high net worth shows the creditors that building your assets was important to you and that you can manage your finances better than someone who has a lesser net worth. In the eyes of the creditor, this makes the individual with the higher net worth a better credit risk and more apt to repay his/her debts.

Condition

The 5 C’s of credit comes to a close with “condition”. “Condition” is how the borrower intends to use the loan. Will you use the money to pay for college, or to fund a vacation? “Condition” also refers to the financial stability of your employer, the industry outlook for the company, as well as current economic conditions and how they may ultimately affect the borrower’s ability to repay the loan.

Understanding the 5 C’s of Credit can help you avoid a financial commitment (and the negative consequences) that you aren’t prepared for.

About Blog

Talking Cents was created by the staff of the nonprofit organization, American Consumer Credit Counseling (ACCC). Not satisfied with providing credit counseling, debt management, and financial education alone, these renegade employees took to the blogosphere in the hopes of helping not only their current clients, but the rest of the world at large to tackle more of the topics affecting people’s everyday financial lives.